Tax-Free Saving: They want you to venture forth

VENTURE capital trusts (VCTs) are just about the most generous investment going from a taxation point of view. The Government is so keen for investors to put money into small businesses, it offers bountiful tax breaks to anyone prepared to back VCTs, which invest in the UK's newest and tiniest companies, most of which do not have stock exchange listings.

You can invest up to pounds 100,000 in a VCT in each tax year. If you buy new VCT shares, you will get income tax relief of 20 per cent. In other words, the Inland Revenue will knock 20 per cent of your investment off your income tax bill for the year.

But the generous tax treatment does not stop there. In addition, all income and capital gains from VCT shares is tax free. Furthermore, you benefit from what is known as rollover relief, which means that if you use gains realised from another investment to finance your purchase, you can defer tax that would be due on those gains until you eventually sell your VCT shares.

With all the publicity surrounding the Government's decision to abolish personal equity plans and Tessas in order to make way for individual savings accounts, it is not surprising that VCT managers are making lots of noise about their funds. "The tax breaks on VCTs look even more generous following the uncertainty over PEPs and ISAs," says Gordon Power, who manages a VCT for Guinness Flight, an investment manager. His group is one of about 10 managers launching VCTs, or issuing more shares on existing funds, before the end of the 1997-98 tax year in April.

Some VCTs are managed by companies whose names are well known by most investors. Murray Johnstone, for example, runs several funds. Others, such as Elderstreet and Oxford Technology, are not such household names.

Before you reach for an application form, however, you should be aware of the substantial risks involved with VCTs. After all, you don't get such generous tax breaks for nothing. VCTs invest in the UK's smallest companies. In fact, they cannot buy into companies worth more than pounds 10m. These companies, often businesses only recently set up and often in high- risk sectors such as biotechnology, are far more likely to go bust than larger rivals. So you certainly should not invest money you cannot afford to lose.

Martin Churchill, director of research at Allenbridge, a performance analyst, warns anyone looking at VCTs not to invest just in order to benefit from the tax breaks. He said: "There is a discussion going on in the industry over whether it is right to describe VCTs as a replacement for PEPs, but I don't believe their risk profile suits that description."

It's not as if you can invest in a VCT and then sell if you decide you have made the wrong decision. If you don't keep your VCT shares for five years, you will have to repay any income tax relief that you have been given. And since only new VCT shares qualify investors for income tax relief and the right to defer capital gains tax, no one is going to buy existing shares. So you may not be able to sell.

If you do decide to invest, picking the right VCT first time is therefore crucial. Mr Churchill suggests the larger funds will be less risky. "The smaller funds, those worth pounds 5m to pounds 10m, won't be big enough to spread their risks," he says.

It is also important to look for funds that invest in companies from several different industries and which are managed by groups that have lots of venture capital experience. VCTs must invest 70 per cent of their assets in qualifying companies within three years of launch or investors lose their tax breaks. So those managers who do not have access to lots of potential holdings might be forced to make poor investments in order to retain their VCT status.

On this basis five of the VCTs on offer stand out. These are Advent VCT 2, Baronsmead VCT 2, Murray VCT 3, Quester VCT 2 and Guinness Flight VCT. But remember that there is a risk that you could lose far more on your VCT investment than you gain from tax breaks.

q Contacts: Advent VCT 2, 0171-630 9811; Baronsmead VCT 2, 0171-600 6655; Murray VCT 3, 0800 289978; Quester VCT 2, 0171-222 5472, Guinness Flight VCT, 0171-522 2111; Allenbridge, 0171-409 1111.

q David Prosser is features editor of 'Investors Chronicle'.